The financial markets of 2014 are very clearly described simply by the chart above. US equities have uniquely diverged from everything else. What matters is why is this so? How long can it last? And what is the best strategy to manage current circumstances?

The starting point comes from understanding that what is driving current conditions to an extraordinary degree is the banking system. In the fourth quarter of 2014, in particular, we saw the banking system shape legislation, stock market prices as well as the financial media narrative.

Markets make opinions and the media has reinforced the impression of US stock index levels as the final arbiter of everything economic. However, any intelligent observer should be able to recognize that this “everything is awesome” narrative is as thin as the printed paper that has produced it.

In an attempt to explain this as clearly and directly as possible I have boiled this down to just three questions that I believe are now crucial for investors to consider.

Finally, while I believe that it is important to recognize that financial conditions and structure are far from optimal, it is also important to find and create solutions. Whatever the outcome of the current predicament, I believe that some plans of action are clearly better than others.

Are bank deposits now unprotected backstops for bank trading losses?

Any failure to comprehend the depravations of the current financial regime must be painfully unaware of the legislation that has just recently been put in place . There are 2 key parts:

What else do you think the banking system is doing against your own interests? Is the stock market level really all you need to know?

Are US stocks right and all other markets wrong?

Just a quick glance at the chart above should make investors wonder how it is possible to reconcile what the markets themselves are telling us. The chart shows the astonishing divergence between three major signals of growth, and the performance of the S&P 500.

Bloomberg’s world growth estimates for 2015 are falling like a stone, and for the second year running. The US Treasury yield curve is flattening back to levels last seen in depths of the 2008/09 recession. This reflects a significant weakening in long term growth expectations. Whether or not short term interest rates go up temporarily, long term rates are signaling a very low level of interest rates as far as the eye can see. Lastly, commodity prices are collapsing at a rate also not seen since 2008/09. This clearly signals weak demand for physical products in line with very weak economic growth.

This is far from an exhaustive list of weak growth indicators. Last week’s article showed 12 market indicators of weak growth.

What else could explain the performance S&P 500, other than massive bank intervention? Clearly as the chart above shows, the S&P 500 fell almost 10% in just a few days in October, as other markets were crashing. Clearly the banking system decided something needed to be done. As we have discussed before Fed Governor Bullard’s statement, and the massive new money printing program by the Bank of Japan were just the most obvious signs of this.

The charts below shows one of the main driving mechanisms for US stocks is the leveraged carry trade out of YEN, which is completely controlled by the Bank of Japan. Almost all up moves in the S&P 500 are preceded with up moves in the US Dollar/Yen. This is how the banking system makes money while the markets are manipulated higher!

Should central banks be in the business of actually reversing natural market development? Is this what you want to bet your savings on? Do you think the banking system is looking after you?

Does declining income and weak capital generation no longer matter for the economy or markets?

Healthy economies are able to regenerate their own capital and improve general income levels. In the period since 2008/09 both of these measures have remained remarkably weak.

Richard Duncan’s analysis (which has delayed release for public consumption) shows that the capital being generated over the last few years of “recovery” has been subpar at best. Then Charles Hugh Smith shows that real median household income has been declining in the US for at least 10 years, and now there will be a substantial hit to energy related income.

In short, neither income or capital generation is yet close to being sufficient to generate healthy and sustainable economic outcomes. This is the prime driver of sustainable economic growth and why interest rates have been stuck at 0% for six years, and why all the positive economic propaganda is failing to resonate with most Americans. It is also why policy makers need permanent extraordinary measures, media spin and market manipulation just to keep the economy at weak growth levels, if they remain resolutely stuck with their current policies.

Essentially, economic policy has now defaulted into a print and pretend mode.

No question the banking system has become immensely powerful. However, there are limits to the current direction of policy, which has become increasingly destructive and is reaching limiting conditions.

Pretend has a limited shelf life. This is currently reflected in the ever more extraordinary measures the banking system needs to take to keep the paradigm in place. The limits are now clearly in sight in the most advanced experiment along these lines. Here is a summary of the status of the current monetary madness in the Japanese economy.

Unprecedented circumstances require creative solutions. The best Strategy for 2015.

These are unprecedented and difficult times for investors. Extreme valuations, divergent markets, extraordinary policy measures that have become seemingly permanent, opaque policy guidance, misleading media coverage, market interventions by the banking system and no safe haven in bank deposits.

Investment risks have risen massively, while dependable returns have become increasingly scarce. The standard methodologies simply are no longer working as they have in the past. Some markets respond to fundamentals while others do the opposite. This destroys any attempt at a balanced mix of offsetting assets, efficient portfolio frontiers, and the normal hedge relationships that asset managers have based their allocation strategies on.

Asset management needs to adapt to the circumstances.

Performance has become determined by the asset focus of the banking system. In the last 2 years this has largely meant US equities or bust as a determination of success, but there are no guarantees. At some stage a severe valuation adjustment will have to take place on most US equities.

Just because a full commitment to US equity markets, trading at record valuations and declining core earnings simply because they are supported by the banking system and the printing press has worked over the last two years, does not make this an everlasting winning strategy. However, this may continue to work for a limited time, but how and when will investors choose a different allocation?

How should investors approach the markets? How should investment management adapt? How can a strategy select the assets that are working now in a systematic way and still work when fundamental values and economic drivers are broken or at least partially impaired? How can such a strategy also include risk management?

The Cycle Dynamic Portfolio.

Start over by reverting to first principles and simplify assumptions to what still remains true despite current difficulties. Then test what can be achieved using the most simple and straightforward methodology.

I am making just a few basic assumptions:

Economic cycles are unavoidable. We may not know the intensity or the length, but there have always been economic cycles, and always will be.

There are a range of different assets that will perform well at different stages of an economic cycles. Choose the one that is working now.

Asset selection can be based on frequent measures of relative strength among these assets. This deals with the timing issue.

This approach ensures participation in any emerging long term trend, and in addition avoids persistent downtrends by frequently checking relative strength, so all underperforming assets will be avoided.

This approach is narrowly focused on trends within a full cycle and only participates while that trend is working. This methodology has been able to function well both in a fundamentally driven market as well as the more unprecedented markets over recent years.

These simpler assumptions are very robust even in current conditions. The rest is basic mathematics. What we find, through extensive research, is that a range of strategies can be found to produce exceptional return for risk results which not only outperform conventional benchmarks over time, but also do so with much lower volatility.

This approach is described in detail with full examples and results here: